What Are Fed Swap Lines and What Do They Do?

The Federal Reserve moved in coordinated action with foreign central banks this morning in order to provide a pressure-release valve for funding markets without exposing the U.S. central bank to much risk.

The Fed announced an expansion of its program that supplies dollars to overseas markets at a cheaper rate. Basically, the Fed lends dollars to foreign central banks in return for their local currency for a specific period. Since the Fed isn’t lending to banks directly, the risk is essentially nonexistent, and it also isn’t exposed to changes in currency rates since the exchange rate is set for the duration of the swap.

The liquidity swap arrangements have a history of use when there are tensions in funding markets. They were used following the terrorist attacks of September 11, 2001and were revived in 2007 and used extensively during the financial crisis, especially after the collapse of Lehman Brothers when credit markets dried up. As market conditions improved, they were shut down in February 2010, but revived in May 2010 as sovereign debt problems began to emerge in Europe. (The Fed has a useful Q&A you can find here, and New York Fed research noted the success of the lines during the financial crisis)

Since their revival in May, the swaps have remained muted. Though the amount in use had increased a bit in recent weeks, the levels of around $2.5 billion are way below even the early days of the financial crisis before Lehman. Today’s announcement further expands the lines through February 2013 and makes it cheaper to access them. It also provides for swaps in currencies other than dollars and euros, if such a need should arise.

The move is more of a pressure-release valve than a direct action, and doesn’t do anything to address underlying problems in Europe. It reduces pressure on markets while policymakers search for a solution and signals that central banks are prepared to act in the event that conditions worsen.

In it’s statement, the Fed said: “U.S. financial institutions currently do not face difficulty obtaining liquidity in short-term funding markets. However, were conditions to deteriorate, the Federal Reserve has a range of tools available to provide an effective liquidity backstop for such institutions and is prepared to use these tools as needed to support financial stability and to promote the extension of credit to U.S. households and businesses.”